Intelligent Investor

January 21, 2018

The current cryptocurrency craze inspired me to re-read the Intelligent Investor by Benjamin Graham. I’ve compiled a list of my learnings, and will keep adding chapters as I read them.

Commentary on the introduction

  • Intelligent investor : Being patient, disciplined and eager to learn. Harness your emotions and think for yourself.
  • Don’t let the roar of the crowd override your own judgement.
  • Obvious prospects for physical growth in a business do not translate into obvious profits for investors.
  • People who now claim the next “sure thing” are no more likely to be right in the end that the hypesters of high tech turned out to be in the dot com bust.

Chapter 1 : Investment vs Speculation

  • An investment operation is one which, upon thorough analysis, promises safety of principal and adequate return. Anything else is speculation.
  • There is a speculative componenet inherent in most common stocks.
  • Speculation is unintelligent when :
    • You are speculating when you think you’re investing.
    • Speculating seriously when you lack the skill.
    • Risking more money than you can afford to lose.
  • Never mingle your speculative and investment operations in the same account nor in any part of your thinking.
  • A margin accoung enables you to buy stocks using money you borrow from the brokerage firm. The collateral for the loan is the value of the investments in your account.
  • Results to be expected by the defensive investor :
    • (6 years ago) 25-75% bonds and converse for stock holdings.
  • Results to be expected by the aggressive investor :
    • Follow policies which are (1) Inherently sound and promising and (2) Not popular on Wall Street.
    • Buying a neglected and undervalued issue is a protracted and patience trying experience.
    • Profiting by shorting stocks is a difficult art to master.

Commentary on Chapter 1

  • For a speculator, the incessant stream of stock quotes is like oxygen- cut it off and he dies.
  • For an investor, Graham urges you to invest even if you had no way of knowing its daily share price.
  • People who invest make money for themselves; people who speculate make money for their brokers.
  • The intelligent investor has no interest in being temporarily right. To reach your long-term financial goals, you must be sustainable and reliably right.
  • Mainstream media turned the stock market into a video game. Everyone was day trading.
  • In the late 1990s, a half-baked opinion on price could double a compay’s stock even as its value went entirely unexamined.
  • Trendy formulas that fell flat :
    • January effect : Buy small stocks at the end of Dec and sell then in Jan, you can beat the market by 5-10%. It worked at first but publicizing this made the effect smaller.
    • Do ‘what works’ : Follow O’shaughnessy’s strategy by buying 50 stocks with the highest 1-year returns, 5 straight years of rising earnings, and share prices less than 1.5x of revenues.
    • The foolish four : Motley fool said (1) Take 5 stocks from DJIA with lowest stock prices and highest divident yields (2) Discard the one with the lowest price (3) Put 40% of your cash in the stock with the 2nd-lowest price (4) Put 20% on the rest (5) Do the same every year (6) Repeat till wealthy. None of the points meet Graham’s definition of an investment (too risky, not diversified, no analysis at all).
  • If you look at enough data, a lot of patterns emerge, if only by luck. Unless these factors cause the stocks to outperform, they can’t be used to predict future returns i.e., coorelation is not causation.
  • The intelligent investor designates a tiny portion of her total portfolio as a mad money acoount for gambling.
  • The gambling instinct is part of human nature- confine and restrain it.
  • Don’t ever confuse speculation with investment.

Chapter 2 : The Investor and Inflation

  • Holder’s of stocks have the possibility that a loss of the dollar’s purchasing power may be offset by advances in their dividends and the prices of their shares.
  • There is no close connection between inflationary (or deflationary) conditions and the movement of common-stock earnings or prices.
  • Don’t just buy stocks and hold them forever. You should sell when they’re high.
  • Gold is good hedge against inflation? Not necessary- you receive no income return on your acpital and incur storage expenses.
  • Stock component is better against large scale inflation than bond component.
  • Footnote : Bernstein disagrees with Graham, stating that gold is really robust in out pacing inflation. Recommendation is to invest in a well-diversified mutual fund specializing in the stocks of precious metal companies and charging below 1% in annual expenses. Limit your stake to 2% of your total financial assets.

Commentary on Chapter 2

  • REIT (Real estate investment trusts) : Companies taht own and collect rent from commercial and residential properties. They do a decent job combating inflation.
  • TIPS (Treasury inflation-protected securities) : US govt bonds that automatically go up when inflation rises. There is one catch- when the TIPS bond rises, IRS regards the increase in value as taxable income (even though its paper gain). Because of this TIPS are best suited for a tax-deferred retirement account like RRSP. TIPS are ideal substitute for the proportion of your retirement funds you would otherwise keep in case. TIPS work best as lifelong holding. They are volatile in the short run. Allocate 10% of retirement assets to TIPS.

Chapter 3 : A century of stock market history : level of stock prices in early 1972

  • PE ratio on < 10 is considered low, between 10 and 20 is moderate and > 20 is expensive.

Commentary on Chapter 3

  • The intelligent investor must never forecast the future exclusively by extrapolating the past.
  • Why should the future returns of stocks always be the same as their past returns?
  • When every investor comes to believe that stocks are guaranteed to make money in the long run, won’t the market end up being wildly overpriced?
  • The stock market’s performance depends on :
    • real growth (earnings and dividends)
    • inflationary growth (rise of prices in the economy)
    • speculative growth (depends on investing public’s apetite for stocks)
  • The markets will most brutally urprise the very people who are most certain that their views about the future are right.

Chapter 4 : General portfolio policy for the defensive investor

  • Rate of return should be dependent on the amount of intelligent effort the investor is willing and able to bring to bear on his task.
  • 50-50 high grade bonds and high grade common stocks.
  • If common stock components are raised to, say 55%, the invetor should sell stocks so its 50-50 again. Vice versa for bonds.
  • Few major types of bonds :
    • US Savings bonds, series e and h : H bonds pay interest semi-annually. Interest on E bonds accrues to the holder through the increase in redemption value. Both offer absolute assurance of principal.
    • Other US bonds
    • State and municipal bonds
    • Corporation bonds
  • High yield bonds : Keep away from these if you’re an ordinary investor. Too much risk.
  • Nonconvertible preferred stocks : The preferred holder lacks both the legal claim of a bondholder and the profit possibilities of the common shareholder. It’s inherently a bad investment form. These should only be bought on a bargain basis or not at all.
  • (I did some research on preferred stock) : Preferred stocks offer investors more protection on insolvency. They also offer greater income security when company is doing well. They pay set dividends on regular intervals, and if the company can’t pay, they issue an IOU to preferred stockholders before common stockholders even get them. However, they are not voting shares. More importantly, they trade at a stable price, leaving little chance to net capital gain. In fact, they are more like bonds.

Commentary on Chapter 4

  • Because so few investors have the guts to cling to stocks in a falling market, Graham insists that everyone should keep a minimum of 25% in bonds. This will give you the courage to keep the rest of your money in stocks even when they sink.
  • Rebalance your portfolio every 6 months.
  • Buy tax free bonds or buy them inside a sheltered account.
  • If interest rates rise, bond prices fall and vice versa.
  • For most investors, bonds funds are better tha bonds. Because you need quite a bit of cash to buy bonds.
  • You can buy treasury bills, short term notes and long term bonds directly from the govt with no brokerage fees.
  • Preferred stocks are bad apparently : if this company is healthy enough for my investment, why is it paying a fat dividend on its preferred stock instead of issuing bonds and getting a tax break?
  • No intelligent investor will buy common stock for its dividend yield alone. The company and business must be solid and the price, reasonable.

Chapter 5 : The defensive investor and common stock

  • Rules for common-stock component
    • Adequate but not excessive diversification. Min 10 issues, max 30.
    • Each company should be large, prominent and conservatively financed.
    • Each company should have a long record of continuous dividend payments.
    • Limit on the price he will pay for an issue in relation to its average earnings over past 7 years : 25 times. This eliminates most growth stocks, but for growth stocks, the harder the rise, the harder they fall e.g., IBM, TI.
  • PE ratio - how much investors are willing to pay for a stock compared to the profitability of the underlying business.
  • Finance has a fasciantion for many bright young people with limited means.
  • There is great advantage for the young capitalist to begin his financial education and experience early.
  • To be considered large, a company should have a market cap of at least $10 billion (in 2003).

Commentary on Chapter 5

  • Defensive investor must always defend against : the belief that you can pick stocks without doing any homework.
  • Find a promising company but do your research next.
  • Familiarity breeds complacency. The more familiar the stock is, the more likely it is to turn a defensive investor into a lazy one who thinks that there’s no need to do any homework.
  • Buying stocks in tiny increments over years can set off big tax headaches.
  • If you dollar cost average on 3 index funds- one for US stocks, one for foreign stocks and one for us bonds, you can ensure that you own almost every investment on the planet that’s worth owning.
  • The knowledge of how little you know about the future, coupled with the acceptance of your ignorance, is a defensive investor’s most powerful weapon.

Chapter 6 : Portfolio policy for the enterprising investor : negative approach

  • Avoid high grade preferred stocks.
  • Avoid inferior bonds and preferred stocks unless they can be bought at bargain levels- prices at least 30% under par for high-coupon issues (bonds paying above average interest rates). When a company is paying you a large interest to raise money, the investment is inherently risky.
  • Avoid foreign govt bonds.
  • Be wary of new issues. Be wary of common stocks with excellent earnings confined to the recent past.
  • It is unwise to buy a bond or a preferred which lacks adequate safety merely because the yield is attractive.
  • Bond prices are quoted in % of “par value”, or 100. A bond priced at “85” is selling at 85% of its principal value. A bond originally offered for $10k but now selling at 85, will cost $8.5k. When bonds sell <100 they are called discount and about >100 are called premium.
  • Second grade bonds and preferred stocks suffer severe sinking spells in bad markets but recover when favourable conditions return.
  • Avoid buying bonds at 100 when they can probably be bought at 70 or less in the next weak market.
  • Owners of foreign bonds have no legal means of enforcing a claim. Avoid.
  • Be wary of new issues, because they have special salesmanship behind them, which calls for a special degree of sales resistance. Also, most new issues are sold under favourable market conditions, which means favourable for the seller and less favourable for the buyer.
  • Bull market periods are usually characterized by the transformation of a large number of privately owned businesses into companies with quoted shares.
  • In every case, the public has gotten burned on IPOs and has stayed away for at least 2 years but always returned for another scalding.
  • Common stock financing has 2 forms (i) If companies are listed already, additional shares are offered pro rata (proportionally) to existing stockholders. (ii) IPOs.
  • Pattern : Somewhere in the middle of the bull market the first common-stock flotations make an appearance. They are priced not unattractively. As the rise continues, more companies do an IPO and the quality of companies becomes poorer. One sign of the approaching end of a bull swing is the fact that new common stocks of small and nondescript companies are offered at prices somewhat higher than the current level for many medium sized companies with a long market history. In many cases the new issues lose 75% of their offering price.
  • The intelligent investor should stay clear of IPOs. Some of these will prove excellent buys- a few years later when nobody wants them and they can be had at a small fraction of their true worth.

Commentary on Chapter 6

  • High yield bonds, or second grade bonds are also called junk bonds.
  • Buying a bond only for its yeild is like getting married only for the sex. When the sex dries up, you’ll find yourself asking, “what else is there”, and its probably nothing.
  • Foreign bonds rarely move in synch with the US stock maket, so you can get a little bit of comfort in your portfolio (but still, you should probably avoid them).
  • Day trading is one of the best ever weapons for committing financial suicide. Your trader will always make money.
  • When you trade, you turn long term gains (taxed at 20%) into ordinary income (taxed at 38.6%).
  • Stock trader needs to gain at least 10% just to break even on buying and selling a stock.
  • On IPOs, we all want to buy the next Microsoft but forget the fact that most other IPOs were terrible investments.
  • Most of the IPO winners are the big investment banks that get shares at the underwriting price before the stock begins trading.
  • IPOs should stand for “It’s probably overpriced”.

Chapter 7 : Portfolio policy for the enterprising investor : positive side